Sunday, April 14, 2013

Why the Fed is more likely to adopt bitcoin technology than kill it off

Paul Krugman has a recent post in which he casts bitcoin as a retrogression from our current fiat system. He's wrong about this. In the next few years, I put decent odds on the guardian of our fiat system, the Federal Reserve, adopting the very bitcoin technology that Krugman finds so dubious. Here is Krugman:

One thing I haven’t seen emphasized, however, is the extent to which the whole concept of having to “mine” Bitcoins by expending real resources amounts to a drastic retrogression — a retrogression that Adam Smith would have scorned.

Krugman has taken bitcoin's colourful jargon a bit too literally. It's best to think of "bitcoin" as a distributed ledger, or a record, and not as physical coin. And while Bitcoin miners do "mine", they're not performing a function that is analogous to gold mining. Rather, they're contributing to the tending and maintenance of the information that makes up the bitcoin ledger. The mining community listens for ledger transfer announcements, processes and verifies them, and then updates the distributed record. The reward for being the first to successfully add to the ledger is new bitcoin. Distracted by this reward, Krugman misses the underlying verification process it represents, thus drawing an incorrect analogy between bitcoin miners and gold miners.

It's better to think of a bitcoin miner as a gold assayer who verifies that a circulating gold coin isn't a fake, or, in our fiat world, as part of the verification process in a credit card payment. A bitcoin miner listens, processes, double checks, and polices the distributed ledger. Protecting a ledger is a valuable use of resources.

Rather than being retrograde, let's see how bitcoin technology could be adopted by the Fed.

The Federal Reserve owns one of the world's most important ledgers. The Fed's 3,000 or so member banks maintain accounts at the Fed. Put differently, they own allocations in the Fed's ledger. Every business day banks trade Fed ledger space amongst each other. The name for the system that facilitates these transfers is Fedwire and the name for the ledger space being transferred is "reserves".

The quantity and size of Fedwire transactions is breathtaking. In the fourth quarter of 2012, 33.8 million transfers were made with an average transfer value of $4.45 million. A total of $150 trillion in ledger space, or reserves, was exchanged.* Many types of transaction are carried out over Fedwire. When company A buys out company B for a billion dollars, the payment will probably be made over Fedwire. If the Fed conducts an open market purchase of $5 billion, it'll pay for that purchase by transferring ledger space over Fedwire. (The size of a single Fedwire transactions is currently limited to $9.99 billion). When John Doe wires a college $80,000 to pay for his daughters tuition bill, ledger space is being moved from John Doe's bank to the college's bank via Fedwire. The lifeblood of the US commerce pumps through Fedwire.

The Fedwire infrastructure is currently hosted at the Fed's East Rutherford Operations Center (EROC) at 100 Orchard Street, East Rutherford, New Jersey (see map below). While most of the world's attention is usually focused on the Fed's Washington headquarters at 20th Street & Constitution Avenue, the importance of Bernanke's office pales in comparison to 100 Orchard Street. All vital information pertaining to the Fed's ledger is maintained on computers at EROC. If a bank wants to transfer ledger space to another bank, the payment is routed to EROC where it is processed and the Fedwire database updated. This system is a hub and spoke system, with EROC serving as hub for its member bank spokes. In the picture at top, it is the system on the left, a centralized network.

Because Fedwire is so important, it needs to be resilient. Should disaster strike at the East Rutherford hub, a secondary back up data center at the Federal Reserve Bank of Richmond is designed to resume Fedwire operationality 60 - 90 minutes later. A third backup center exists at the Federal Reserve Bank of Dallas.** The weakness of the system is that if the hub is destroyed (and the second and third backups) then the entire payments infrastructure disintegrates.

An alternative (and perhaps cheaper) way to build a resilient payments system would be for the Federal Reserve to adopt a bitcoin-style distributed ledger. The Fed's ledger would no longer be stored at EROC. Rather, all member banks would hold a copy. Much like a bitcoin miner "mines", a member bank would be an independent node responsible for helping to maintain the ledger's integrity. Should a bank want to exchange ledger space, the transaction would be announced to the network of member bank nodes who would in turn poll each other to verify the legitimacy of the transaction. Once a consensus has been arrived at, the payment would be processed and the Fed's ledger updated. As a condition of membership in the Federal Reserve System, banks would be required to act as verification nodes.

What would be accomplished is a decentralization of the information contained in the Fed's ledger. The ledger would be everywhere rather than at one spot. Transfers of ledger space would no longer be patched through the central processor at EROC but would be handled by a distributed network of cooperating nodes. Whereas the current hub and spoke system has two levels of redundancy, Richmond and Dallas, a distributed system has no central hub and therefore much more layers of redundancy. It would be very difficult to destroy it. Such a system is represented in our top chart by the network on the right, in which no entity is more important than the other.

All of this is an exercise in speculative economics, of course. But I like to think there's a grain of truth in it. Whether you agree with me or not on the possibility or likelihood of the Fed adopting a bitcoin-style distributed ledger as the basis for Fedwire, at least you'll see why Krugman has been too hasty in writing off bitcoin as a retrogression. Distributed ledgers are cutting-edge and will have many applications in the future.

PS. In the burst of attention over the last few weeks, the press and pundits have all become a bitcoin experts, just like they were Cyprus experts in the previous news cycle. There are three blogs worth reading that offer more stable and permanent bitcoin fare. Peter Surda wrote his thesis on bitcoin, so do go by and check his blog The Economics of Bitcoin. Jon Matonis has payments industry experience and has been following bitcoin for far longer than myself or any journalist. He blogs at The Monetary Future. Finally, Mircea Popescu owns and operates MPEX, the largest bitcoin stock and options exchange, and knows all the excruciating detail of the system's inner functioning. He blogs at Trilema.

* Fedwire statistics**Payments, Clearance, and Settlement: A Guide to the Systems, Risks, and Issues by the General Accounting Office (1997) PDF

22 comments:

1. I doubt they'd want to do that because all transactions would be more or less public.But maybe that's nothing a billion dollar outsourcing deal can't fix because as opposed to Average Joe, the Fed needs security and anonymity.2. Can Bitcoin be redesigned to anonymize only CBs' transactions?Maybe, but I'd expect them to pull something like a search-and-replace bastardized version Bitcoin called something like Fedcoin, with their own encryption and of course the ability to produce an unlimited number of virtual coins, at will.According to an anonymous Fed source, based on special request by the Chairman, a CTLR+P key combo was added to an early beta version of Bitcoi-based Fedcoin client compiled for Mr. Bernanke.

Folks, don't miss the most valuable Bitcoin article of the day:www.bloomberg.com/news/2013-04-12/virtual-bitcoin-mining-is-a-real-world-environmental-disaster.html

I don't understand the nuts and bolts of designing these sorts of systems, but is it far-fetched to assume that an intelligent team of programmers could come up with an anonymous ledger?

Here's a different perspective. So what if points on the Fed's ledger can be publicly matched to a bank? It gives banks a way to monitor other bank's health and self-police the payments system.

To a certain degree, the Fed's ledger is already public, since we can see banks' reserve holdings in their quarterly reports. And I'm sure banks already have a good idea about who's getting discount window lending, even though this is supposed to be anonymous.

@Anonymous: if Bitcoin were to be redesigned on a "completely different network" (I'm not sure what that means, to be honest), how would that work? That sounds fishy to me (to me a completely independent version makes more sense), but maybe you're right.

@JPK: the Fed itself surely can surely monitor a lot using the current system, but general public cannot. I would imagine in case of a Lehman Brothers-like situation the Fed wouldn't be able to shield many more organizations from collapse (had those used a variant of Bitcoin which exposed transactions to general public).Because value Bitcoin would add to general public (aka "the outsiders") would be relatively higher vs. what the insiders would get, I doubt this would be accepted by TPTB. This argument is similar to the argument that attempts to explain why gold is not fully monetized by the banking system, especially in the US - it'd make many things more transparent than they are supposed to be.For example, if we knew how much money the Fed lends to the ECB, that'd be a valuable near-realtime stress indicator that's currently simply not available. Even if they anonymized it, seeing $100 bn of bitcoins sent from X accounts to Y accounts would be telling.

A FEDWIRE needs to be non-repudiable instantly. A consensus system adds delay and some level of repudiation (by introducing conflicting data to one of the parties polled).

Now having a distributed system where the conch can be passed to any node which would then serve as the master sounds like what the Richmond and Dallas nodes are already providing.

Bitcoin's gathering of consensus is because it explicitly cannot trust any node to be the "master" other than one node essentially chosen at random whose batch of transactions are then later confirmed by other nodes that are chosen at random.

Why does a Fedwire transaction need to be non-repudiable instantly? Does the introduction of a delay + repudiability bring Fedwire to its knees? It seems to me that this is more about tradeoffs. One sacrifices immediacy for resiliency.

I appreciate your analysis, even though I not always agree with it. I'm sure many others feel the same, and would be glad to send you a token of their appreciation. "Getting paid for this stuff" is as easy as making your Bitcoin tip address visible in the top section of your blog.

Having a de-centralized ledger is only one of many design aspects of Bitcoin; I can imagine the Fed is interested in this aspect but not in many other aspects (such as guaranteeing a limited amount of currency in circulation; making financial blockades impossible; making anonymous payments possible). The system proposed by the article sounds feasible, but calling it Bitcoin wouldn't do justice to Bitcoin itself.

While you might be right about the Fed's adopting bitcoin-style technology, I think you're wholly wrong about Krugman's point. Bitcoin is potentially an extremely regressive social development, even if it could be used, in certain circumstances, for progressive purposes.

Mining bitcoins and mining gold are highly structurally analogous, and, needless to say, the parallel between mining bitcoins and assaying gold eludes me. The fact computer viruses have already been developed to turn one's computer into a bitcoin-mining 'slave' not-so-lightly hints at the kind of dystopian possibilities that lie ahead.

Bitcoin is an anonymous currency, just as gold is and was. The question is whether this anonymity, in the aggregate, contributes to social development, productivity expansion, resources sustainability, and similarly. This question is a political economic question, not a moral one, and my answer would be absolutely not. The fact of the matter is that anonymity, in the aggregate (again), is a tool most used by those who engage in negative labor (economic rentiers, speculators, gangsters, drug dealers, corrupt politicians, and similar ilk.) It's not clear to me why, say, an elementary school teacher or an electrician, etc., in a progressive society (in which it is okay to be homosexual, or not to marry, or to engage in casual sex, or what have you) needs to hide the records of his or her interpersonal relations beneath a vale of anonymity (on some level, who cares?).

If bitcoin does not represent retrogression, it doesn't represent progression either. That the Fed might adopt such technology probably corresponds with its alignment with elements of negative labor.

Perhaps you'd feel better if I didn't use the word bitcoin. Let's just rename this post: The Fed should consider the use of distributed ledger technology.

So tell me why ledgers should be centralized and not distributed. Imagine a non-anonymous distributed Fed ledger as described in my post. Only regulated banks can hold and trade Fed ledger space. All banks can see each other's locations in the ledger and witness transferals of ledger space. The Treasury and the Fed can see the ledger too. What are the pros and cons relative to the current centralized Fed ledger?

I guess I would agree that this kind of decentralized, distributed accounting system could prove less susceptible to various kinds of disasters (earthquakes, warfare, flooding, etc.)

And I shouldn't, I guess, conflate anonymity with authenticity. One could create a bitcoin-like system in which transactions are not anonymous at all, and the processing power used to generate the 'coins,' or the 'fabric' of the ledgers, would be economically justified in its ensuring their authenticity.

What I'm concerned about, and what Krugman, I think, is concerned about, is a question of degree. What proportion of total resources ought to be dedicated to ensuring a monetary system? Surely some, and surely not all. There should be some kind of happy medium. The concern is that bitcoin crosses Sorites' line. My additional concern is that the way bitcoin is structured -- in some ways, as a testament to neo-libertarianism -- the burden is liable to be dumped on the weak (think: poor people with old computers, old people with old computers, libraries, etc.), and in this way we're back to square one.

Still, you're right, the technology could be pointed in different directions.

"What proportion of total resources ought to be dedicated to ensuring a monetary system?"

That's a tough question. Whatever the market requires, I suppose. There's a tricky balance between cost and quality.

Plenty of back office time and resources are already devoted to maintaining the Fed's ledger (or any other centralized ledger, for that matter). It could be the case that distributing the ledger to the nodes provides a higher quality system for less cost.

Distributed ledgers don't seem libertarian to me. They're apolitical... just a useful way to organize and manipulate data. A firm operating in a libertarian free market might find that a centralized ledger is convenient whereas a communist organization might choose a distributed ledger.

Why not also TBillCoin? The safety of zero-coupon USG debt, with 'guaranteed' value at a specific future redemption date... plus the easy transmission, subdivision, and pseudo-anonymity of a cryptocurrency.

That is, once we're just pushing buttons to transfer numbers on a crypto-fortified global ledger, why shouldn't I be able to directly spend $0.99 worth of a TBill to buy a smartphone app?

Indeed! Check out [bitcoin colored coins] for some ideas on how a specific Bitcoin 'genesis transaction' can already be used to embed tradable, voting equity shares into the Bitcoin blockchain.

Maybe these other ledgers benefit from being in the same global blockchain -- common defense against certain threats, and the ability to do atomic stock-for-coin transactions -- or maybe they'd benefit by being separate. (Perhaps each company/project can fork and seed its own shareholders' network, using some standard open-source packages.)

Cryptoequity may be an idea that's as big or bigger than cryptocurrency.